Business Damages: Evaluating & Measuring

Measuring Business Damages

EVALUATING BUSINESS DAMAGES

VALUATION of a small business to determine business damages in litigation is often difficult.  Particularly if the business shows a loss on its income taxes.  Our experience is that the majority of clients who run small businesses overestimate the value of their businesses, and–consequently–overestimate their losses.

The courts are crowded with people arguing over valuing everything from the income-stream of a mom-and-pop corner store to a market advantage in the sale of complicated technology.  This article is limited to an overview of issues that affect the valuation of small businesses with limited fixed assets and debt financing.  Here are some of the basic questions our firm asks when looking at a small business damages claim.

QUESTION 1: Lost profits or increased expenses?  When looking at a profitable business, it is easy to quantify how much money the business was making before and after the event giving rise to the lawsuit.  Subtract, and you have a defensible business loss as business damages.

However, if the business is not profitable, or not very profitable, looking at profits can undervalue the loss.  Just because a business is not profitable does not mean that there was no business loss.  There are three ways our firm thinks about capturing increased business expenses as business damages when there are no lost profits.

(1) Increased demise of the business.  Sometimes the breach of a major contract, a competitor’s unfair business practice, the misappropriation of trade secrets, a personal injury to a key employee, or other “wrong” giving rise to a lawsuit is the last nail in the coffin of a struggling business.  The rapid demise of a business can create its own additional losses.  There is a significant difference between the timely dissolution and sale of an ongoing business concern versus a “fire sale” price precipitated by an unexpected unfair business practice, failure to pay on a major contract, or unexpected injury to a business owner.  A look at cash flow can uncover the difference.  If a business had revenues of $300,000, against expenses of $450,000, it is losing $150,000 a year.  But, when the injury or business wrong occurs, the revenues can fall much further, while many fixed expenses stay the same.  If the business is a type that is regularly bought and sold (e.g., restaurants, bars, brokerage companies), there are experts who can assist in valuing the difference between the value of an ongoing business and one that has ceased (or nearly ceased) operations and needs to be liquidated at a fire sale.

(2) Unavoidable fixed costs and unrealized expenses.  Even if a business can be shuttered easily, that does not mean that the expenses of the business can be avoided.  For example, lease obligations and equipment rentals that cannot be avoided become a business loss.  It is worth looking at pre-injury business investments into projects that were abandoned because of the incident being sued over.  For example, investments in leases, insurance, licenses, remodels and the like are all investments that the business may have anticipated recouping, and which can justify a business damages award.

(3) Key-employee replacement costs.  In the case of a business owner whose suffered a personal injury, there are additional staffing costs and increased hours by existing employees while the business owner is unable to work.  In addition, sometimes we can look at the average wage for what the business owner did and argue that the benefit to the business of their work was at least what they would have been able to receive on the open market.

QUESTION 2: Is the income in cash? A surprising number of businesses are profitable even though they do not generate significant (or any) cash for their owners.  The rental business is one example.  Many landlords are in the business as part of a long-term strategy to acquire property, even if there is no income coming out of the business.  Other businesses are carefully set up to generate tax losses through–for example–depreciation of fixed assets or amortization of intangibles like patents or goodwill, and thereby offsetting other business income.

QUESTION 3: When does the money come in, and what part is from future repeat business?  The easiest business to look at are those–like retail stores–that make money on each transaction at the time of the transaction.  However, it is often the case that income is spread over many years and may come in long after the business owner’s work is done.  For example, insurance brokers often earn a percentage of the premium paid every year the insured buys the insurance.  Because many people do not change their insurance from year to year, a sale by a broker in Year 1 often means income in Years 2, 3, 4 and 5.  The same is true for many professionals (doctors, dentists, lawyers, accountants) who expect income from future follow-ups.  What this means is that an interruption in the business in Year 1 can cost our clients in Years 2, 3, 4 and 5.  One way to inquire into this is to ask, how much of the business income is passive, and how much of it is repeat customers?

QUESTION 4: Do the tax returns reflect reality?  Businesses are permitted to keep two sets of books: one for the purpose of taxes (cash accounting) and the other for their investors (accrual accounting under Generally Accepted Accounting Principles GAAP)  Plenty of tax preparers have creatively found ways of making all or nearly all of their client’s income disappear from the tax returns.  It can be hard to explain to a judge or jury that, even though the business owner told the IRS that they were not profitable, the business in fact had significant income that justifies an award of business damages.  The way we lawyers get around this to look, in detail, at what business expenses (tax deductions) are unavoidable when the business is not operating or operating in a limited manner, and argue that those expenses were a legitimate business expense before the incident or injury and will be a legitimate expense going forward, justifying a business damages award.

CONCLUSION: The lesson is simple: small business people are often too busy running their businesses to understand the value of their businesses.  So when representing small business owners in business injury litigation– whether it be unfair competition, breach of contract, theft of trade secrets, or personal injury to the business owner–smart lawyers dig into the business books to understand the dynamics of the business.  Otherwise, we may either undervalue the losses or mistakenly overestimate them when calculating the amount of business damages.

If you or your business has suffered a loss or injury for which you deserve compensation, feel free to contact us at Shenfield & Associates.

Christopher Shenfield, at Burlingame, February 15, 2016

 

License Agreements: 10 Tips

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Unintended Consequences

WHEN NEGOTIATING LICENSE AGREEMENTS, you want to get a long-term deal that protects your intellectual property while securing maximum revenue stream. To do so, avoid doing these 10 things.

  1. Make Sure Scope of the License Equals the Scope of Obligation to Pay Royalties.  Be careful not to create  loopholes in your payment clauses that do not capture the value of your licensee’s exploitation of the granted  rights.  A  common example is granting the right to “use” a licensed technology without specifying that such use be  subject to royalty  payments (in addition to actual sales).

Typical agreements might state that a licensor “grants to Company the exclusive worldwide license in the Field under the Licensed Patents to make, use, offer to sell, and import Licensed Products.”

Make sure to include “use” in the definition of Net Sales. For example:

“‘Net Sales’ shall mean the amounts received by the Company and its Affiliates and Sublicensees from the use of Licensed Products or other practices of the Licensed Processes (to the extent not covered by sales herein below), and from the sale of Licensed Products.”

2. Have Clear Diligence Requirements. In spelling out post-license milestones, avoid language that merely requires the licensee to “use its best efforts” to achieve them.

A weaker requirement might state:

“Company shall use its best efforts to achieve the following commercial goals (the Milestones) by the dates set forth below.”

A stronger clause might read:

“Company shall use its best efforts to bring Licensed Products to market. In partial satisfaction of its diligence obligations, Company shall achieve the following commercial goals (the Milestones) by the dates set forth below.”

3. If Possible, Have Minimum Annual Royalties Start During the Latter Stages of Product Development.  Allowing a licensee to delay royalty payments until the first commercial sale can mean a long wait for payments.  It also erases the diligence value of the minimum royalty provision. To help promote diligent development of products, it is wise to start minimum royalties during the latter stages of product development, if possible.

4. Seek Reimbursement of Patent Costs.  Most licensing agreements require the licensor to handle all patent activity, yet many agreements don’t seek advance payment or at the very least timely reimbursement, particularly with respect to different countries.  My suggestion is try getting the following clause in your agreement:

“Any patents in a particular country for which payment is not received shall be removed from this agreement.”

cross-licensing of technology and intellectual property5. Pay Attention to Termination and Dispute Provisions. Considering the many notices and cure periods typically included, it may take six months or more to terminate a license for breach. I recommend a shortened dispute resolution provision for payment disputes. Barring that, at least make sure the agreement allows interest to accrue on payments that are held up during the dispute.

6. Make Sure Your Agreement Requires the Licensee to Mark Products. A critical element of patent enforcement is that any products include the word “patent” or the actual patent number on the packaging or on the product itself, fulfilling the “constructive notice” requirement to qualify for damages. Neglecting to mark the products can open the doors to infringement and prevent monetary settlements.

7. Specify Payment for Future Rights, and for Heaven’s Sake, Put in a Time Limit!  Along with a time limit, I recommend trying the following language:

“For each Improvement Invention selected to be added as Licensed Patents, Licensee shall pay to Licensor a New Invention Fee of $X.”

8. Eliminate Unnecessary “Indemnification” for  Patent Infringement.  A patent by definition cannot infringe on another’s patent (the United States Code defines infringement as making, using, selling or importing into the U.S. a patented product).  Eliminate any indemnification for claims that a patent “infringes” on another party’s intellectual property from the agreement.

9. Put In a “Grant-Back” Clause. You do not want the Licensor to infringe on its own patents.  I recommend trying the following clause:

“The above grant is subject to a reservation of rights by Licensor for itself to practice, and have practiced by other not-for-profit entities for purposes of collaborative research with Licensor, under the Licensed Patents for educational, research, patient care and treatment, and other internal purposes. Licensor further excludes from the license granted herein the right to bring an infringement action against … any Inventor or their present or future not-for-profit employers, for infringement of any of the Licensed Patents in carrying out not-for-profit research.”

10. Avoid Disappearing Royalties.  Future royalty payments can disappear if careful attention is not paid to seemingly minor provisions, or if future scenarios are not dealt with properly in the licensing agreement. Here are some areas to watch for:

  • royalties that are based on a small component of a product, and not the whole product.
  • royalty obligations that terminate after a set number of years.
  • royalties are tied to a licensed product, but only derived products ever reach the market.
  • royalties based on the cost of goods sold, rather than on sales price.
  • royalties based on a fixed amount that does not escalate with time.
  • not including reach through provisions for sublicenses.

If you have any questions about this article, need help in negotiating and drafting an effective, profitable licensing agreement, or representation in breach of licensing agreements (including dispute resolution or litigation), please contact Chris Shenfield at 650.373.2054 or chris@shenfieldlaw.com.

Top 5 Issues That Every Business Needs To Know About When Negotiating Distribution Agreements

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Distribution Agreement

A DISTRIBUTOR AGREEMENT (a/k/a DISTRIBUTION AGREEMENT) is a contract between a  manufacturer and a  distributor that stipulates the responsibilities of both parties.  Because a  distributor takes a more active  role than that of a mere wholesaler, a great distributor agreement is  critical to ensuring success when  growing into new or expanding markets.

Here is a checklist of five key issues to consider when drafting your next  distributor agreement.

 1. Exclusive or Nonexclusive.  Distributor franchises may be either exclusive (where there will be  no other distributor franchised in the territory) or nonexclusive (where the new distributor might be one of several distributors franchised in the territory).  Distributors often appeal for an exclusive territory, arguing that without exclusivity, the distributor has no incentive to allocate adequate resources toward development of sales for the manufacturer.  Once a manufacturer agrees to an exclusive territory, it forfeits the opportunity, for a period, to franchise an additional distributor.  Assignment of an exclusive distributor in a territory often represents an unnecessary leap of faith on the part of the manufacturer.  One alternative to granting an exclusive territory is to draft the distribution agreement in such a way that the distributor is nonexclusive, but to franchise only one distributor.  If a manufacturer’s objectives were met, no additional distributor would be added to the nonexclusive territory. Such an arrangement provides encouragement for the distributor to perform without restricting options of the manufacturer.

2. How Fast, and How Much. Every new partnership between a distributor and a manufacturer is born in a period of bright optimism.  But like marriage, there is a limit on the number of partnerships in which a manufacturer or distributor may engage. By aligning with a new distributor, a manufacturer is prohibited from singing an alternative distributor.  By aligning with a new manufacturer, a distributor is prevented from immediately signing an additional manufacturer. When aligning with a new distributor, it is important to assign a territory that is not too large initially. If a distributor is proven in only small territory, it is generally not a good idea to assign a large territory and hope for the best.  A better approach would be to open a new distributor relationship in that distributor’s proven territory and expand the territory gradually, after results in the smaller territory suggest that an expanded geography makes sense.

3. Termination for Cause and Convenience.  Less experienced partners sometimes attempt to allow for termination for a limited set of specific causes.  However, partners sometimes disagree over the presence of cause, or responsibility for cause.  Many distributor agreements allow for termination for cause and for termination for convenience.  When an agreement allows termination for convenience, a partner wishing to disengage from the agreement serves Notice of Termination to the other partner with 30 days notice.  When the convenience clause is invoked, cause and responsibility for cause need not be argued.  Legal confrontation is avoided.  The parties are able to focus on their customers and businesses without consuming management time, corporate focus and financial resources on attorneys, courts and arbitration.

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Supply Chain

 4. Annual Termination and Semiautomatic Renewal.  Annual termination and semiautomatic renewal  are best practices when it comes to distribution agreements.   In these cases, there is a provision in the agreement  calling for termination of the agreement at the end of the first year after the agreement is placed in effect, and  each year thereafter. Terms and conditions allow either party to submit a Notice of Intention to Not Renew 30  days prior to the end of the calendar year.  When annual termination and semiautomatic renewal is written into the agreement, both parties have the opportunity to exit the agreement, without proving cause, once per year. The partnership is held together by performance and not just words in an agreement.

5. Frequency of Price Changes and Amendments. Distributors sometimes believe that they would have a competitive advantage if their manufacturers are allowed to adjust prices only once per year. This may serve the distributor well, but at the expense of the manufacturer.  This arbitrary advantage can torpedo many a partnership.  During periods of inflation or other rising costs, the manufacturer must have the opportunity to pass along increases in cost. The marketplace will control against aggressive price increases. Allowing the manufacturer to increase prices upon 30-day notice eliminates one opportunity for conflict and reinforces the principle of fairness.   With respect to amendments, it is important to remember that external factors periodically apply pressure to the distributor and manufacturer. Those pressures sometimes call for a change in the distributor agreement. If the agreement allows changes to be made throughout the year, there is little problem. However, if the agreement allows for changes only once per year, one or both partners must survive undue pressure until the agreement can accommodate such an annual change. The best distributor agreements allow changes to be made throughout the year.

Conclusion.  DISTRIBUTION AGREEMENTS are key to constructing an effective relationship between a distributor and a manufacturer. A well-written agreement can assist in developing that relationship. The agreement cannot extend the life of a relationship once the relationship expires. A poorly written agreement often leads to a legal disputes that consume management time and financial resources and can lead to legal disputes.  A well-written distribution agreement can eliminate expenditure of resources on these unproductive activities and encourage productive, healthy relationships between the distributor and manufacturer.